Rudiments of a Ponzi scheme

The scheme is named after Charles Ponzi, who duped thousands of New England residents into investing in postage stamp speculation in the 1920s. But Ponzi is not the original mastermind behind the scheme; various reports show that there were several similar scams before he was born. (Charles Dickens’ 1857 novel “Little Dorrit,” for example, described such a scheme whereby the fraudulent dealings of Mr. Merdle led to the collapse of his bank.) Ponzi’s operation, however, took in so much money that it was the first to become widely known in the United States. Ponzi promised investors that he could provide a 50% return in just 90 days, at a time when the annual interest rate for bank accounts was 5%. Based on the arbitrage of international reply coupons for postage stamps, Ponzi quickly diverted investors’ money to support payments to earlier investors and to himself.

As originally designed, a Ponzi scheme remains a fraudulent operation that pays returns to separate investors, not from an actual profit earned but from the investors’ own money or money paid by subsequent investors. The scheme typically entices new investors by offering returns that other investments cannot guarantee, in the form of short-term yields that are either extraordinarily high or unusually consistent.
The main reason why the scheme initially works is that the early investors, those who actually got paid the large returns (from the investments of new entrants) reinvest their money in the scheme. Meanwhile, the fraudsters gain the investors’ confidence, maintaining the deception of high profits. Claims of a “proprietary” investment strategy, which must be kept secret to ensure a competitive edge, frequently is touted to hide the fraudulent operation.

The fraudsters also try to minimize withdrawals by offering new plans to investors, often freezing their money for a long time in exchange for higher returns. If a few investors do wish to withdraw their money in accordance with the strict terms, the requests are usually promptly processed, giving the illusion to other investors that the fund is solvent.

But once the required continuous stream of investors slows down, the scheme begins to collapse as the fraudsters start to have problems paying the promised returns (the higher the returns, the greater the risk of collapsing). Such liquidity crises often trigger panics, as more people start asking for their money, similar to a bank run. (A bank run, also known as a “run on the bank” occurs when a large number of customers withdraw deposits because they believe the bank is, or might become, insolvent.)

External market forces, such as the global economy decline in 2008, also cause many investors to withdraw part or all of their funds, not necessarily because of fraud suspicions, but simply due to underlying market conditions. (In Madoff’s case, the fund could no longer appear legitimate after investors attempted to withdraw $7 billion in late 2008.)

And of course, there is rarely a happy ending to this story as fraudsters attempt to vanish, taking the remaining investment money with them.

August 10th, 2011|Educational Series, Fraud|

Turning to lie detectors for investment confidence

Media reports say that amid the still unsettled regulations in the wake of the financial crisis, affluent investors are turning to behavioral specialists, looking to find things in the faces and phrases of their fund managers that may not be revealed in financial statements.

Eccentric screening techniques are nothing new to Wall Street. Seigmund Warburg, founder of the investment bank S. G. Warburg & Co., was known for subjecting customers and employees to psychological tests, and evaluating hand-writing samples of job applicants. And these days, requests for deception detection are on the uptick, as acknowledged by lie detector professionals who are turning down repeated orders to analyze subjects for Wall Street firms.

Earlier this year, intelligence sources disclosed to the publication Politico that the CIA, within tight guidelines of its employment policies, allows agents to moonlight in the private sector, and that some of them work as “human lie detectors.” Calling deception detection an “arcane field,” Politico reported that such experts recognize the verbal and nonverbal cues that indicate someone may be lying, and the people under scrutiny never know they’re being evaluated. Politico recounted an incident from 2005 where a large hedge fund, through a third-party, retained CIA-trained analysts to remotely listen in on a quarterly earnings status call from executives at UTStarcom. During the call, the agents noted some suspicious responses by the interim CFO, and specifically about revenue recognition. They subsequently cautioned that the company most likely would post poor results in the third-quarter. And sure enough, the prediction came true: a day after the below-expectations results were released, the stock closed at $5.64. It had been trading at $8.54 when the CIA listened in on the call in August.

So exactly what verbal clues tipped off the agents? In this case, it was a “detour statement” when the interim CFO qualified his response to a revenue recognition question by referring back to an announcement from a previous quarter, and avoided further comments on any related issues. The executives on the call also projected low confidence, had an underlying concern and did not readily come forth with information.

According to corporate lie detection experts, there is a myriad of verbal clues that may be indicators of dishonesty. Shifts in language patterns, such as switching from the first person to the third person, i.e., suddenly speaking on behalf of “the firm” or “the team,” and quick “rehearsed” responses may be red flags. Statements that contain the words “honestly,” “frankly” or “basically” and phrases such as “as I said before” and “I swear to God” also have been linked to deception. Attacking the questioner with “How dare you ask me something like that?” too may point to someone who is uncomfortable with the untruth, as well as having a selective memory as indicated by the phrase “to the best of my knowledge.” Additionally, complaints – “How long is this going to take?” – and overly courteous responses – “yes, sir” – have been found common in liars.

And of course there are physical indicators of lying, with the main ones being facial twitches, changes in breathing tempo, and dilated pupils. Professional human lie detectors say that people who are uneasy with deception will show that in motions such as micro-expressions—brief flashes of fear or other changes in a face—or concealing positions like crossing legs, or sitting motionless. Shifting anchor points, grooming gestures such as adjusting clothes, hair or eyeglasses, picking at fingernails, and cleaning the surroundings by straightening paper clips on the table or lining up pens are also possible indicators of honesty transgressions.

Skeptics, however, abound. In a May 2010 report, even the Government Accountability Office called into question the effectiveness and the scientific foundation of deception detection techniques. And many experts agree that even the most common dishonesty signs are not universal and detection is most effective when the analyst can establish an “honesty” pattern and then look for deviations.

When screening a fund manager, investors still like to see experience, a consistent record and good returns. And a comprehensive background investigation that provides such information may be more predicting of future behavior and honesty than a Pinocchio’s nose. But human lie detectors can identify “hot spots” for extra probing, and combined with a traditional due diligence, buy investors a reasonable peace of mind.

January 4th, 2011|Educational Series, Fraud|

More on fake Web sites

Bogus company Web sites mimicking government entities and promising easy money SECare sprouting in record numbers. In March, the SEC issued warnings to investors about a fraudulent Web site set up by a company named International SecurityInvestor Protection Corporation (ISIPC) which claimed that $1.3 billion in Madoff money has been found in Malaysia and urged Madoff victims to submit personal information to verify that they are on the restitution list. The site copied most of the content and design of the Securities Investor Protection Corporation Web site, and provided links to several legitimate government entities such as the United Nations, the International Monetary Fund, the World Bank and the IBA, falsely touting their sponsorship. (The SIPC is a non-profit organization created by Congress in 1970 toprotect customers in the event of a brokerage failure, acting as a trustee or working with independent court-appointed trustees to recover funds).

Two months after the ISIPC made its debut, the SEC posted an alert that a Web site for an entity calling itself the “US Securities and Equities Administration” was attempting to dupe investors by claiming that funds were being held by the U.S. government on their behalf, and asking for upfront fees to collect the funds.

One of the easiest ways to spot government-related online scams is to look at the Web site and e-mail addresses. No U.S. government agency has a Web site or e-mail address that ends in anything other than “.gov”, “.mil”, or “”.

July 15th, 2010|Educational Series|
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